The euro zone has made significant efforts to reduce its trade imbalances since
the outbreak of the financial crisis. In 2009, only Germany, the Netherlands
and Austria had a current account surplus, while all the other countries, in
particular France, Italy and Spain, ran current account deficits, resulting in
a deficit for the zone as a whole (−0.7% of GDP). Five years later, in 2014,
the situation had changed radically. The euro zone had a large current account
surplus (3.4% of GDP) with almost all the countries running a surplus.

It should nevertheless not be concluded that the euro zone has corrected its
trade imbalances, as there are still several reasons for concern. Firstly, some
of the current account surplus is cyclical, particularly in southern Europe,
due to depressed domestic demand. Secondly, the magnitude of the euro zone’s
current account surplus comes with deflationary risks: while for the moment the
ECB’s expansionary monetary policy is helping to contain upward pressure on the
euro, this pressure will eventually materialize once the monetary cycle enters
a phase of normalization, leading to imported deflation and losses in
competitiveness vis-à-vis the rest of the world.

More importantly, the reversal of the euro zone’s current account position
vis-à-vis the rest of the world does not mean that the zone’s internal
imbalances have been corrected. The analysis that we made in the 2016 iAGS
report shows
that there are still significant imbalances, although they have diminished
since the start of the crisis.

Based on a model to simulate changes in the current accounts of the euro zone
countries in terms of price competitiveness differentials [1], we calculated
the nominal adjustments within the euro zone needed to achieve balanced current
accounts for all the countries. A balanced position is defined here as
stabilization of the net external position, at a level compatible with EU
procedures (i.e. greater than −35% of GDP), and with the output gaps closed in
all the countries.

The table below shows the results of these simulations and helps to take stock
of the adjustments made since the beginning of the crisis as well as the
adjustments still needed relative to Germany, which is used as a reference
point.

here were still significant nominal misalignments in the euro zone in 2014.
Several groupings of countries can be identified. Austria and the Netherlands
are on level footing with Germany. In contrast, Greece must undergo a nearly
40% depreciation compared to Germany, despite its previous sacrifices; even if
the Greek current account is close to balanced today, this is due to the output
gap that has widened considerably (−12.6% in 2014 according to the OECD) and
artificially improved the external trade balance by shrinking domestic demand.
Between these two extremes lies a group of countries, including France, Spain,
Portugal, Belgium and Finland, which need a depreciation of about 20% relative
to Germany. Italy meanwhile is in a somewhat better position, with a relative
depreciation of about 10% required, thanks to its current account surplus (1.9%
of GDP in 2014) and a relatively favourable net international investment
position (−27.9% of GDP).

These nominal imbalances cannot be solved by changes in exchange rates, since
the countries all share the same currency. The adjustment thus has to be made
through relative price movements, i.e. by differentials in inflation rates
between countries. Thus, inflation in Germany (and the Netherlands and Austria)
needs to stay higher for a while than in the intermediate group, which itself
needs to be higher than in Greece. And, given the importance of wages in
determining the price of value added, this outcome will be achieved mainly by
differential changes in nominal unit labour costs.

There are several possible ways to achieve this goal. The one that has been
followed so far has been to make the reduction of labour costs the norm, based
on a non-cooperative race for competitiveness. With Germany making extensive
efforts to hold down its prices and wages, other countries could adjust only by
cutting their own costs, whether through wage cuts (as in Greece and Spain) or
by lowering corporate tax (as in France). While these strategies have indeed
helped to reduce imbalances in the zone since 2008, as our table shows, the
adjustment is still far from complete, and the economic cost has been high.
Lowering wages in the southern European countries undermined demand, and
therefore business, while deflationary pressures were strengthened and are
still threatening, despite the ECB’s energetic policies.

Another approach would be to coordinate wage developments in the euro zone
countries in order to allow the ECB to meet its inflation target of 2%, while
making nominal readjustments. Each country would set a target for changes in
its unit labour costs. Countries that are currently undervalued (Germany,
Netherlands, Austria) would set a target of over 2%, while overvalued countries
would set a target that was positive, but below 2%. Once the imbalances were
absorbed, which would require a number of years, the targets could be
harmonized to 2%.

The relative adjustment of unit labour costs could also be made through
differential gains in productivity. This point highlights the importance of
investment stimulus policies in the euro zone, so as to improve the
productivity and competitiveness of countries that need to make significant
nominal adjustments. Using this approach to adjust unit labour costs would
release some of the downward pressure on wages and domestic demand in the euro
zone.

A policy like this would represent a profound change in the economic governance
of the euro zone, and would call for enhanced cooperation. This is, however,
the price for maintaining the cohesion of the monetary union.